Will This Bernanke's Put Force us to Buy Real Ones?

By Martin Hutchinson
Director of Global Investing Research

After weeks of water-cooler speculation, the U.S. central bank’s policymaking Federal Open Market Committee yesterday (Tuesday) slashed the benchmark Federal Funds rate by half a percentage point, to 4.75%. It was the first reduction in U.S. interest rates in four years.

This strategy – of sharply cutting interest rates every time the stock market, or the economy – skidded into a rough patch, used to be known, quite sardonically, as a “Greenspan Put,” in honor of former Federal Reserve Chairman Alan Greenspan.

The move itself will have made Jim Cramer, Larry Kudlow and many other stock traders very happy. The commensurate Louis Roederer Cristal/ Dom Pérignon champagne indicators will no doubt stage a strong sympathy rally this evening.

But I would argue that the rest of us should very seriously consider purchasing some “put” options.

Let me explain …

Rate Reduction Redux

As I said in my column yesterday, I believe that a rate reduction of this magnitude will touch off a resurgence in the U.S. economy – but with a cost, as I expect that we’ll see inflation begin its upward march.

However the text of the Fed’s statement, and some new data yesterday, raises a disquieting alternative possibility: Perhaps Fed Chairman Ben S. Bernanke knows something ‘bad’ about the U.S. economy, that the rest of us aren’t at all aware of.

In the statement released following yesterday’s meeting, Fed policymakers claimed that the rate cut was needed to “help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.”

At first glance, it smacks a bit of the indecipherable “Fedspeak” that former chairman Greenspan perfected and used to such great advantage during his tenure as the head of the nation’s central bank. Indeed, the statement doesn’t even seem to make sense.

Sharks and Shysters and Crooks, Oh My

You see, a high percentage of the subprime mortgages that touched off the growing global credit crunch were either fraudulent, or chimerical. Sometimes crooks and shysters just lied about their income to buy houses, assuming the market would bail them out. At other times, financially simple souls – the proverbial supermarket cashier, or shoe-store clerk – genuinely thought they would be able to afford a $700,000 California house on an $11 per hour wage.

Neither of these two categories will be helped by the reduction in interest rates. In fact, even if those rates dropped to zero, chances are that neither class of borrower could afford the principal repayments or the property taxes on the houses they’d purchased. [Well, I suppose it would be possible if lenders could make zero-amortisation, zero-interest-rate, and 100-year mortgages – and then report them on their books at 100% of their value – since no payments would be missed until 2107!].

The subprime-mortgage mess has caused the money markets to seize up like a Bentley with a leaky crankcase, and that’s no surprise. With modern financial techniques such as securitization and asset-backed commercial paper, nobody had the faintest idea where all this toxic junk ended up, so it’s not surprising that banks wouldn’t lend to each other. The solution, which we’ve seen, is for central banks to lend money “into” the market to make it liquid again. As was true of the prior examples, lower interest rates have no benefit here, either.

However, as I hinted at a little earlier, it is also possible that Bernanke & Co. at the Fed have sighted some nasty storm clouds forming directly in the path of the U.S. economy. Employment unexpectedly dropped by 4,000 last month and yesterday we heard that the NAHB Housing Market Index had dropped to a record low. If there’s a real storm brewing, the Fed was right to slash rates so aggressively. On the other hand, since real economic trouble will bring lower corporate profits, the stock market was mad to zoom upwards.

Playing the Rate Cut

But here’s the good news: You can capitalize on either of these possible scenarios. Take part of the money you had earmarked for investing, and follow the strategy I detailed yesterday, buying shares of the IShares Comex Gold Trust (IAU) exchange-traded fund (ETF). The increased inflation – which the rate cut is very likely to bring – together with a weak dollar and higher commodity prices, will be reflected in a higher gold price. If the U.S.S economy is in reasonable shape, it will take a year or so for the Fed to figure out that inflation is a real problem, and zap rates higher; meanwhile gold prices will zoom.

If, on the other hand, the U.S. economy is in real trouble, the stock market will eventually reflect it as corporate profits fall. To protect yourself against that eventuality, you should buy some put options. I would suggest the long-term Standard & Poor’s put options quoted on the Chicago Board Options Exchange (CBOE: SPX) as a suitable choice.

Buy the longest-dated options possible (currently December 2009) because that gives this scenario time to play out. Also, buy puts that are well out of the money, with strike prices at 1000-1200, compared with the S&P 500 Index’s current level of 1518. Why? Because they’re cheap, that’s why. You’re not going to invest a huge chunk of your money in options – that’s a sucker’s bet. However, if Ben Bernanke really knows something he isn’t telling us, it’s likely the market will fall quite a long way. And if the options have a long time span until they expire, out-of-the-money puts have plenty of time to move into the money, should the market drop – meaning they will be worth many times what you paid for them.

As well as making you money directly – via this little strategy I’ve outlined here – long-dated put options provide some insurance for the rest of your portfolio, in case of a market collapse.

Finally, if you want to avoid the challenges and risks of trying to guess just what the Fed’s up to, I suggest you invest your money in a market as far away from the U.S. economy as possible. And, as I said yesterday, that would be in Japan.

Invest in the streetTracks SmallCap Japan ETF (JSC), which consists mostly of domestically oriented Japanese companies, safely insulated from the ongoing U.S. financial shenanigans.

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